Regulatory Capture is Not “Inevitable”

“Capture” has become a self-fulfilling prophecy of economists who turn their students into sure-to-fail regulators.

William K. Black

A Wall Street Journal editorial asserted the “inevitability” of regulatory capture and called for replacing financial regulation with “simple rules” that “can’t be gamed.”

“Once one understands the inevitability of regulatory capture, the logical policy response is to enact simple laws that can’t be gamed by the biggest firms and their captive bureaucrats. This means repealing most of Dodd-Frank and the so-called Basel rules and replacing them with a simple requirement for more bank capital—an equity-to-asset ratio of perhaps 15%.”

The editorial specifically invoked George Stigler as the authority for this claimed “inevitability.” It cited no source for its facially absurd claim that reported capital levels cannot be “gamed.” George Akerlof and Paul Romer emphasized this absurdity in their 1993 article on looting—and explained why it was strange that they had to emphasize such an “obvious” point.

“We begin with a point about accounting rules that is so obvious that it would not be worth stating had it not been so widely neglected in discussion of the crisis in the savings and loan industry. If net worth is inflated by … accounting … incentives for looting will be created. *** [E]ach additional dollar of artificial net worth translates into an additional dollar of net worth than can be extracted from the thrift” [Akerlof & Romer 1993: 13].

Top bankers, of course, have always understood this “obvious point.” Jamie Dimon (JPMorgan’s CEO), made the point in his March 30, 2012 letter to shareholders:

The WSJ passage quoted above inadvertently illustrates the true face of financial regulatory “capture” during the run-up to the financial crisis—ideological idiocy about finance and financial elites. The federal regulators, particularly Alan Greenspan and Timothy Geithner, did not fail to regulate because they were “captured” by the banks they were supposed to regulate. They were captured by their ideology, which saw the elite banks and bankers as the solution rather than the problem. The banks and the bankers were supposed to provide the “private market discipline” that made markets and contracts efficient, and their paramount concern for “reputation” was supposed to keep them acting as if they were honest and as if they were seeking to help their customers.

“‘Well, Brooksley [Born], I guess you and I will never agree about fraud’ [Alan Greenspan]

‘What is there not to agree on?’ [Born]

‘Well, you probably will always believe there should be laws against fraud, and I don’t think there is any need for a law against fraud,’ she recalls. Greenspan, Born says, believed the market would take care of itself.” [Former Commodities Futures Trading Commission Chair Brooksley Born’s account of a famous encounter between herself and Alan Greenspan]

Federal regulators were captured by their ideological biases, created by economists and writers who constructed a fantasy world in which top bankers would never engage in fraud or rig the system against the customer. The regulator’s proper function under this fantasy was to get out of the CEO’s way and let him work his genius. The CEOs knew how easy it was to “game” any “accounting residual” such as capital or income—and they gamed them massively in the savings and loan (S&L) debacle, the Enron-era frauds, and the most recent crisis in order to optimize their looting. People in the grips of ideological nostrums are most likely to implicitly assume out of existence such an “obvious” point as the bank CEO’s ability and perverse incentive to game reported capital and income. “Capture” has become a self-fulfilling prophecy of economists who turn their students into sure-to-fail regulators crippled by their ideological economic fantasies.

But capture is not inevitable. The reason that the S&L debacle was contained and did not produce a financial crisis is that the ideological economist Richard Pratt, who deregulated and desupervised the industry, was replaced by a non-economist, Edwin Gray, who actually listened to the examiners in the field and to the findings in their “autopsies,” which demonstrated that the problem was looting led by the CEOs. The vigor of Gray’s reregulation and resupervision of the industry enraged the industry and led to an unintentionally hilarious line by the economist Daniel Brumbaugh.

“[T]he thrift industry has captured its regulatory process more thoroughly than any other regulated industry in the country” [Daniel Brumbaugh, Thrifts Under Siege: 1988: 173].

If the S&L industry really was the most successful industry in the thoroughness of its capture of its regulators, then Gray (and a later successor, Timothy Ryan) demonstrated that even the “worst” capture can be arrested within weeks of the arrival of a leader who is not ideologically captured. Pratt proves my point: the S&L industry detested him, and the feeling was mutual. He was “captured” by his anti-governmental ideology, not the industry.

(Note: William K. Black is an associate professor of economics and law at the University of Missouri-Kansas City and a former senior financial regulator)

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